Is Social Security Becoming a Bad Deal for American Workers?

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social securitySocial Security is one of the most contentious government programs ever created. Although millions of past and current retirees have relied on it for a big part of their income, others have criticized the program as a Ponzi scheme that's doomed to eventual failure.

Recently, Social Security reached a milestone that's sure to add fuel to the highly charged policy debate. For an increasing number of new retirees, the amount that Social Security will pay out in benefits will end up being less than the payroll taxes they paid into the program over the course of their careers.

social securityMoving Down the Scale

For some retirees, this is nothing new. High-income earners have been in this negative-return situation for quite a while.

According to analysis from the Associated Press, though, many middle-income retirees now face the same situation. Moreover, even if nothing happens to reduce benefit levels going forward, the trend is likely to continue and affect more retirees with even lower incomes.

The Push and Pull of Social Security

A few factors go a long way toward explaining exactly why this shift is happening. On one hand, with the exception of the past few years, the amount of payroll taxes that workers pay has steadily risen. During the initial years of the program, from 1937 to 1949, the portion of payroll taxes earmarked for Social Security was locked at 1%. That amount steadily rose during the ensuing decades, hitting 2% in 1954, 3% in 1960, 4% in 1969, and 5% in 1978. The current rate of 6.2% held steady since 1990, although the temporary payroll-tax cut reduced that rate by 2 percentage points. So today's retirees have had more of their earnings subject to high rates than those in earlier generations.

In addition, the amount of wages on which the government collects payroll taxes has marched inexorably upward. As recently as 1972, Social Security taxes applied only to the first $9,000 in annual wages that a worker earned. This year, that figure has climbed above the $110,000 mark.

Social securityOn the other side of the equation, the formula that determines monthly payments from Social Security doesn't match up in a straight line with average career earnings. Instead, Social Security has what it calls "bend points" above which every additional dollar of earnings yields a smaller increase in your monthly benefit. For instance, in 2012, the first $767 of average monthly earnings produces a benefit of $0.90 per dollar, while additional earnings up to $4,624 boosts monthly payments by $0.32 and income above that increases a payment by $0.15.

The bend points in the benefits formula explain why higher-income retirees fell below the breakeven point earlier than middle-income retirees. Because taxes rise at a constant rate but benefits provide diminishing returns as income levels go up, the redistributive effects of the program hit those with higher incomes first.

It's important to remember that Social Security covers a lot more than just retirees directly. With spousal benefits, as well as payments to a surviving spouse and minor children after your death, many payments from Social Security go to other people. Moreover, with disability insurance coverage, you may get benefits long before reaching retirement age if something happens to you.

Worse to Come?

Perhaps the scariest part of this analysis is its assumption that benefits will continue at their current levels. In the latest report from Social Security's trustees, projections indicated that, left unchecked, benefits would have to drop by about a quarter in the year 2033 because of shortfalls between the amount of payroll taxes collected and benefits owed to retirees.

In this election year, most politicians have been afraid to tackle Social Security head-on. But with increasing pressure to justify the benefits of the program, you may see reform efforts appear once the election is over -- especially if more members of the public start seeing the program as a bad deal.



For more on retirement: Motley Fool contributor Dan Caplinger isn't taking Social Security for granted. You can follow him on Twitter @DanCaplinger.

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